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Volatility in Public vs. Private Markets

March 30, 2020

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Amidst the recent turmoil, a frequent refrain from multifamily boosters is that volatility in publicly-traded stocks is a signal to move into private assets like real estate syndications. Those raising capital for real estate syndications make the claim that their investments have less volatility than the stock market – I’ve seen countless Facebook posts by sponsors boasting that their real estate holdings haven’t dropped by 20%, unlike the stock market. However, private real estate holdings are also volatile – they are just not marked to market daily. A multifamily property may not have a ticker symbol but it still has a market price affected by current conditions. Real estate values may well be headed lower – it will just take longer to show up in pricing since some sellers will stick with yesterday’s price until forced to accept today’s price. If real estate buyers are concerned about future apartment demand and job growth as well as the turmoil in the financing markets, they may adjust their offers from a 5% cap rate to 6% – a decline of more than 16% in value.

The benefit of investment in private, illiquid assets, however, is not that it is insulated from volatility or market shocks, but rather that it makes emotional decisions much harder. Buying and selling stocks is simple, instant, and cheap. This makes pulling the buy / sell trigger much easier when fear or greed takes over. Conversely, selling real estate or even an illiquid partnership interest is a months-long process involving many steps and bearing high transaction costs.

Debt is Key

Real estate is a risk asset and values are inextricably bound to capital markets since almost all real estate investments are financed with debt in addition to equity. Cap rates loosely follow the 10-year US treasury bond yield since most commercial real estate debt is priced based on the 10-year US bond yield plus a spread. Credit spreads vary and the spread between cap rates and the cost of debt varies as well based on investor demand and market outlook (rent growth, etc.). All of this is to say that cap rates should only be marginally impacted at this point since downside risks should be somewhat offset by a lower treasury yield. The 10-year yield has fallen by 40% in the last month creating potential for improved cash flows, assuming favorable financing can be obtained. The trouble with times of distress is that credit markets freeze up, making it difficult to get deals done with optimal debt.

The great paradox of the market cycle is that when the deals are good (assuming a price correction occurs creating strong discounts), money is not available, and when the deals are bad (fully priced, top of the cycle), money is abundant. However, one of my favorite sayings is: “price is permanent, financing is temporary” – it may pay to be opportunistic and buy deals at the right price, even if favorable debt – or any debt – is not immediately available.

Cash Flow is King

Perhaps a greater benefit of private real estate in these tough times, beyond illiquidity preventing rash decisions, is that it generates cash flow. Cash flow – not just cash – is king. The best thing in an illiquid environment, with fewer sellers and thin credit markets, is to not need liquidity at all. Real estate returns have both a cash flow component and market value component – and the underlying cash flows are far less volatile than the asset price itself. This means that your cash flow could remain steady even while asset value in the market is temporarily depressed. Conversely, stock market investors, relying on the stock’s market value rather than its dividends, could be forced to sell during a market decline such as the one we are currently experiencing. With cash flowing assets, cash flow not only keeps the investment solvent, it can also help keep food on the table in tight times.

So, while illiquid investments aren’t insulated from public market volatility, they do benefit from illiquidity as well as high transaction costs and even more so from their generally stable cash flows. The most important thing is to have resolve and reserves and even double down via a capital call if necessary in order to make it through difficult periods in order to capitalize on the good times when financing is easy and buyers are plenty.